From the time of your last meeting until the Toronto summit, the dollar traded steadily but with an increasingly firm undertone in the light of improving trade figures, some better economic statistics and tighter Fed policy. believed that the Group of Seven ( G - 7 ) But the market

monetary authorities would

act to limit any significant increase in the dollar, as well as any decrease, and that helped keep the dollar trading in a fairly narrow range. However, on June 21, the Summit communique and

accompanying statements by officials were interpreted as indicating that the G-7 might tolerate more of a rise in the dollar than the market had previously anticipated. At that point the dollar's uptrend gained momentum as market participants scrambled to adjust hedges and cover short dollar positions that had been built up since late last year.
By this week the

exchange rate had risen to levels that led to substantial central bank sales of dollars. Dollar rates today are around 6 to

percent above the levels at the time of the May FOMC meeting. Going back to the time of your last meeting, the exchange
markets at that point were sensitive to indications that
international adjustment might be undermined by inflationary
pressures in the United States. There were concerns that
capacity constraints might limit further improvements in our
trade balance and lead to inflationary bottlenecks. By early

June, however, some of these fears began to dissipate, at least
in part because statistics on the domestic economy suggested that
these pressures were not developing as rapidly as expected.
Equally if not more reassuring was the evidence that the Federal
Reserve was already responding to the early signs of inflationary
pressures. Indications that the Fed had tightened its stance

appeared to provide considerable comfort to the foreign exchange
market, and a widening of short-term interest differentials
supported the dollar.
Meanwhile, the market was becoming increasingly impressed
with the dollar's continued ability to trade within a fairly
narrow range. Participants seemed convinced that the Federal

Reserve and other G-7 monetary authorities would keep the dollar
reasonably stable. Investors world-wide became less concerned

about exchange rate risk and more willing to respond to
attractive interest rate differentials. We started to hear

evidence of outflows from the German mark and from other
continental currencies going into assets denominated in the
dollar and other high-yielding currencies.


these capital flows intensified in late May and early

June, the market wondered how the Bundesbank and other foreign monetary authorities would react to the dollar's rise. Bundesbank felt itself in a difficult situation. The

With German

monetary aggregates already swollen by last year's intervention sales of marks and continuing to grow more rapidly than targeted this year, the German central bank became more and more troubled by the inflationary consequences of a weakening exchange rate.

By early June, officials of Germany and a number of industrial
economies were also openly expressing concerns about rising
commodity prices and a potential rise in inflation worldwide.
Thus, although market participants responded favorably to better

statistics and signs of Federal Reserve tightening in

early June, they began to anticipate that foreign monetary authorities would take advantage of increases in U . S . interest rates to raise their own rates, and they continued to feel that officials would take action to contain the dollar's rise through intervention. Reports had begun to circulate in the markets beginning in
early May that the Bundesbank was selling substantial amounts of
dollars. In fact, during May and early June the Bundesbank had

quietly sold all of its interest earnings and other dollar
receipts accrued since the beginning of the year. Then the

Germans started then to sell dollars visibly at the Frankfurt
fixing, and subsequently in the open market. In total up to the

time of the Summit meeting the Bundesbank dollar sales amounted
to about $5-112 billion. The market proved able to absorb these

dollar sales in an orderly fashion and, once the market began to
realize this, the dollar gained further strength.
At the close of the summit, the communique issued by the repeated the precise words of the last December's


that is, "either excessive fluctuation of exchange rates, a further decline of the dollar, or a rise in the dollar to an extent that becomes destabilizing to the adjustment process could be counterproductive by damaging growth prospects in the world

economy. '' But though the same words were repeated in the June communique, suggesting that some rise in the dollar was more tolerable to the

than any decline, the response this time was

different as conditions were in some ways different.


particular, at the time the June communique was issued, --First the dollar was at the time of the December

percent higher in terms of DM than statement, so that tolerance for


a higher dollar started from a higher base. --Second, the previously bullish sentiment towards the yen
had begun to weaken, and prospects for yen bond and stock prices
had deteriorated.
--Third, banks' customers were sitting on large short dollar
positions which had been established since late last year to
protect them from dollar declines but which would result in
losses if the dollar were to strengthen much more.
Thus, when many in the market interpreted the Summit communique, along with reported comments of various G-7 officials, as reflecting greater tolerance toward a higher dollar than they had expected, a scrambling to cover short-dollar positions set in and dollar rates moved up quickly for the rest
of last week.

On Monday this week, the buying pressure was again

intense and the Desk entered the market, buying $170 million against marks in operations that began in the morning and resumed later in the day. On Tuesday, the Bundesbanks sold almost $750 Together the European The Desk was at first

million and other Europeans joined in.

central banks sold $1.4 billion that day.

reluctant to follow up on these European operations lest the market believe the U.S. was actively trying to push the dollar down. But when later in the day the dollar moved up to levels

that exceeded those of Monday, we reentered the market to sell
$150 million against marks.

On half of the U . S . dollar sales on

Monday and Tuesday, or $160 million, was for the Federal Reserve, and I request your approval of these operations. Today we did not enter the market in an open and visible
way, as we did Monday and Tuesday, but we did purchase
dollars, for $200 million, no discreet operations, using

agents so as to avoid detection. We made purchases only as the
dollar was rising, and mainly at levels higher than those we had
seen in recent days and weeks. We think it is very useful to

accumulate these balances to provide more resources for future
The Desk has not operated openly in the market in Japanese yen. The dollar has risen about 5 percent against the yen since

the December

meeting as compared with a rise of about 12 The Desk has continued to take the

percent against the mark.

opportunity to buy small amounts of currencies from customers for the Federal Reserve. We purchased

million equivalent of

yen, as well as $1.5 million equivalent of Deutsche marks in this fashion. In other operations during the period, the Argentine central bank repaid $160 million of its swap agreement with the U.S. Treasury. The U . S . Treasury and the Bank for International

Settlements, on behalf of its member central banks, provided $250

million in short-term credits to the National Bank of Yugoslavia. The National Bank of Yugoslavia drew the $50 million of its swap with the U . S . Treasury on June 15.


Notes for FOMC Meeting
June 29-30, 1988
Peter D Sternlight

In carrying out domestic open market operations since the last meeting of the Committee, the path allowance for adjustment and seasonal borrowing was raised in two steps, by a total of $150 million to a level of $550 million. First,

directly in line with the May directive, the borrowing allowance was increased from $400 million to $500 million on May 25--about a week after the meeting. It was anticipated that this step-up

in borrowing pressure would be associated with a move in the Federal funds rate from the neighborhood of 7 percent to around
7-114 percent.

As it worked out, the implementation of this

change, interacting with market expectations and to some extent with seasonal reserve pressures, tended to produce funds rates closer to 7-318


7-112 percent by mid-June.

Against this

May background, and also in light of the 88asymmetric8f directive
and the continuing flow of information suggesting well sustained
economic growth, it was deemed appropriate to accept or validate
the slightly higher funds rates that had emerged in the market by
increasing the path level of borrowing a little further, to $550
million--as reported to the Committee at the June 22 conference
call. This level of borrowing was expected to be associated with

funds trading continuing in the 7-112 percent area.
Borrowing levels have run fairly close to path during
the intermeeting interval. The greatest deviation came in the

first maintenance period when borrowing bulged over the Memorial
Day weekend and produced about a $580 million two-week average-­
compared to the $500 million path level set midway through that
period. In the next maintenance period, ended June 15, with the
For the

path at $500 million, borrowing was about $480 million.

two-week period ending today, borrowing has averaged about $515
million thus far--with the path again having been adjusted midway
from $500 to $550 million.
While borrowing was close to path, Federal funds tended
to run a bit higher than expected over most of the interval.
Even in the first reserve period, when funds averaged about 7-114
percent, that reflected a first week around 7-118 and a second
week, which followed the rise to a higher borrowing path, average
slightly over 7-318 percent. The 7-318 percent average persisted

through the second maintenance period, ended June 15, while in
the final reserve period, ending today, trading has more
typically ranged around 7-112 percent, and even higher in the
last couple of days as we were up to the quarter end. Some of

this added firmness apparently reflects seasonal pressures
associated with the June tax date and quarterly statement date.
In addition, market expectations have worked in the direction of
anticipating some snugging of policy in response to signs of
sustained economic growth and potential inflationary pressure.
Desk operations were confined to temporary reserve
adjustments during the period. Apart from routine exchanges of

maturing issues there were no outright transactions, as the


zig-zag pattern of needs to add or drain reserves did not present
significant opportunities for sustained moves in either
direction. For about the first week of the interval, reserves

were over-abundant and were drained through several matched-sale
purchase transactions in the market. Starting May 27, the Desk

was on the add side, providing temporary reserves on most days
through repurchase agreements. Until June 23 these all took the
In the last several

form of customer repos of varying size.

days, the projected size and duration of needs were such that we
undertook some multi-day System repurchase agreements as well.
Responding to higher money rates and short-term funding
costs, most short-term market rates rose about 15 to 40 basis
points over the period. Treasury bills rose about 15 to 40 basis

points, with longer bills showing the smaller increases.

and six-month bills were auctioned last Monday at 6.59 and 6.75
percent, respectively, compared with 6.28 and 6.50 percent just
before the last meeting. The Treasury continued to pay down

bills modestly during the period--a net $1.6 billion--but is now
reaching a point where they will start building up bill issues
again. In fact, yesterday, the Treasury announced a small

increase in the weekly bills to be sold next week.

moderation, some build-up in bill issues would be welcome in the
market, relieving scarcities that have tended to distort usual
rate relationships as official holdings (Federal Reserve and
foreign accounts) have tended to absorb rising proportions of
weekly bill issues in recent quarters. Rates on private short-


term instruments such as Cds and commercial paper also rose about
30 to 4 5 basis points over the period, while there has been some

anticipation that a rise in bank prime rates may not be far off. For intermediate and longer-term issues, it was a different story--with a variety of cross-currents and much dayto-day volatility leading to little net change in the intermediate area and declines of about 10 to 25 basis points at the longer end. Initially, the long-term market was set back

when the March trade deficit was reported with its sharp rise in exports, as this was read as implying inflationary pressures ahead. The first reported upward revision in first quarter GNP

to nearly

percent reinforced this impression. The long bond

yield climbed as high as 9.36 percent from 9-118 at the start of the period. But by late May prices began to turn around. For a

time the rally was considered merely a "technical*Imove in a I1bear"market, and some would still hold that view, but over time some investor buying did develop. It was encouraged by hints of

moderation in the economy's advance, still-moderate behavior of broad price measures, a reduced trade deficit for April with particular attention paid to a reduction in imports and, of increasing importance as the period progressed, a markedly strengthening dollar. At one point, the Treasury's long bond

yield came down to about

percent, only to push back above 9,

and then fluctuate day to day to end the period roughly around
8.90 percent.

Even with bond prices showing net gains, investor

participation has been spotty and lacking in real conviction,

from what we hear.

Moreover, to some extent, the strong

performance of the long bond, with its net yield decline of about

20 basis points reflected a growing expectation that the Treasury

would lack sufficient authority to sell more bonds in August, or
perhaps for even longer. The Treasury’s 10-year note came down a

more modest 12 basis points or so over the period and now yields
just a whisker less than the active long bond. Meantime, the

Treasury raised about $6-1/2 billion in the coupon sector.
while news on the economy tended to suggest some
slowing of growth and broad price measures remained moderate,
inflation concerns were by no means put to rest. The economy was

still expected to be strong enough to continue pressing against
capacity in a number of lines, and there is widespread sentiment
that the rate of price increases will drift higher by perhaps a
percentage point or so over the next 6 to 12 months. Higher

commodity prices, while recognized as largely reflecting the
drought situation, also kept price concerns alive, though the
market did not get quite as wrapped up in commodity prices as it
has in some recent past times. Against this background the
market has rather anticipated and even welcomed a sense that the
Fed was tugging a bit on the reins--and indeed this may have been
an additional factor imparting some strength to the longer
maturity issues.

As to where the market currently perceives policy to be

centered, ideas range around $500 or $500-600 million for
borrowing, with funds expected to be around 7-318 to 7-112


percent, or perhaps more evenly centered around 7-1f2 percent.
The rates above 7-112 in the last couple of days are widely
regarded as temporary products of quarter-end pressures. There

is little anticipation of dramatic further policy moves on the

immediate horizon, but there is a sense among many participants
that policy will continue to edge to the firmer side as the year
Finally, a couple of words about Desk dealer relationships: Around the end of May, the Desk began trading

with three additional firms--CRT Government Securities, Lloyds Government Securities, and Nikko Securities. All three had been added to the primary dealer list about six months earlier. With those additions, we were trading with dealers.

of the 4 2 primary

In mid-June First Interstate Capital Markets withdrew

themselves as a primary dealer because of the pending sale of their dealer operation, and then just a few days ago we added three other firms to the primary dealer group: Dillon Read, S.G.

Warburg, and Wertheim Schroeder. This brings the published primary dealer list to

The press has noted that no new

Japanese dealer names were added to the primary dealer list-­ although the latest list does show a name change for an existing primary dealer to reflect its new Japanese bank ownership. While not saying so publicly in so many words we have in fact deferred consideration of another Japanese dealer firm that might well have qualified at this time in order to allow more time to see additional complementary actions by the Japanese in opening their

financial markets, and especially the Japanese Government bond
market, to U.S. firms. In the past, it has been possible to

point to such complementary actions when adding new Japanese
names and we'd like to continue this approach to encourage the
further opening of their market.


Michael J. Prell
June 29, 1988






We shall be referring to the materials labeled "Staff
Presentation to the Federal Open Market Committee."
The first chart outlines the key assumptions in the staff forecast. As regards monetary policy, we have based our projection on the premise that the System would place a priority on avoiding any deterioration in underlying inflation trends--a deterioration that we think likely unless aggregate demand decelerates considerably. On the fiscal policy side, we are not anticipating that any additional restraint will be applied, beyond bhat was mandated in the Budget Summit agreement last fall. Under the circumstances, we believe that interest rates probably will be trending upward, at least into the first half of next year. As you know, it has proven difficult in recent years to get even the direction of rate movements right; with that caveat, I note that we have built into our forecast an increase in market yields of something over a percentage point. Such a rise should induce an appreciable

increase in M2 velocity; consequently, we expect that M 2 growth will slow in the second half, producing an increase of around 6 percent for this year and 4 percent for 1989. The velocity of M3 is less sensitive to interest rate movements, so M3 growth should exceed that of M2. On exchange markets, the dollar is projected to come under pressure again and to decline moderately on balance by the end of r.ext year.

- 2 -

Chart 2 provides an overview of our economic forecast. As you know, the Colnnerce Department released revised first-quarter numbers after the Greenbook was published. However, because those revisions didn't change the picture materially, we didn't attempt to incorporate them in this presentation. Real GNP, the black bars, is now estimated

to have risen at a 3.6 percent annual rate in the first quarter--rather than 3.9 percent--and we have projected only a modest slowing--to 3-1/4 percent--in the second quarter. In our forecast, output decelerates noticeably this sumner and growth averages just a touch above 2 percent from now through 1989. Although a decline in auto assemblies explains a part of the near-term slowdown, another major factor is o u r assumption that drought will substantially reduce farm output and that the national income accounts will put a large portion of that effect into the third quarter. Were it not for this stab at assessing the effects of the drought, we would have had a bit more growth in the second half of this year, and a bit less in 1989. As indicated by the red bars, domestic spending is projected to continue lagging output growth, mirroring the ongoing external adjustment. Consistent with the below-trend output growth we are
forecasting, we are anticipating a small increase in the unemployment
rate, as depicted in the middle panel.
On the price side, data through May indicate a considerable
pickup in inflation in the second quarter, and we see that higher rate
of price increase persisting until the latter part of 1989.

- 3 A

major element in our projection of weak overall growth in

domestic demand is a continuation of sluggish consumer spending, shown at the top of chart 3 . Over the six quarters ended in March, real PCE

rose at an average of only 1-1/2 percent per annum. During the projection period, spending is expected to rise at that same rate.

you can see, we have outlays tracking disposable income quite closely.

Real income expansion is constrained by two influences: slower
employment growth and a continuing erosion of nominal wage gains by relatively rapid consumer price increases. This weakness in real income is symptomatic of the terms-of-trade loss associated with the lower exchange value of the dollar.
As indicated at the right, we are projecting that the personal

saving rate will remain around the higher level recorded since the stock market break. To be sure, this is still a low level historically, but there are no signs that consumers are on the brink of a further notable retrenchment. The ratio of household net worth to income, shown at the middle left, has recovered the ground lost last fall, and while we would anticipate lackluster stock market performance in the projected economic environment, the overall financial position of the sector should hold up well. Consumer sentiment seems to be quite positive at this time: both indexes shown at the right have rebounded smartly since last fall. Higher interest rates will be a deterrent to household spending
on big ticket items and the item with the biggest ticket is, of course,
a house. We believe that the drop in housing starts to less than a 1.4
million unit rate in May was something of a fluke, but we expect that--

- 4 -

after a near-term rebound--starts will move back down to that level by
early 1989. The slide in construction activity occurs in the single-
family sector as mortgage rates push upward; high vacancy rates will
work along with rising financing costs to damp multifamily building, but
we think that this segment is at or near a bottom nationally.
One volatile area, and thus a point of risk area in any forecast, is inventory behavior. As may be seen in the top panel of

chart 4 , nonauto inventories--the red bars--rose at a brisk pace in the fourth and first quarters, and we have estimated a further sizable addition in the second quarter. To date, most of the accumulation seems to have been voluntary. With sales trends improving and supplies becoming harder to get, it is not surprising that manufacturers have been building inventories. Moreover, as the middle left panel shows, given the upswing in prices, the real carrying cost for stocks of materials and supplies has declined sharply over the past couple of years. At the right, you can see that stocks generally remain lean in
manufacturing. Such excesses as there are seem to be in the trade
sector. The bottom panel highlights a few features of recent inventory
developments. Manufacturers and wholesalers have accounted for the bulk
of the accumulation since last fall, and much of the increment to stocks
in those areas has occurred among firms involved in producing or
distributing capital goods or industrial materials, for which demand has
been robust. In contrast, a lesser part of the accumulation has
occurred at retailers. Although apparel stores are widely reported to

- 5 -

be burdened w i t h unwanted i n v e n t o r i e s , t h e i r s t o c k s a p p a r e n t l y haven't changed: level. weak demand has h e l d t h e i r stock-to-sales r a t i o s a t a high

Among g e n e r a l merchandisers, on t h e o t h e r hand, a combination of

s l u g g i s h demand and inventory i n c r e a s e s has e l e v a t e d stock-to-sales ratios. We've a l r e a d y seen t h e r e t a i l inventory s i t u a t i o n feeding back t o some s o f t n e s s i n consumer goods production r e c e n t l y , and t h a t l i k e l y w i l l continue; but, i n o t h e r s e c t o r s , t h e recent pace of s t o c k accumulation i s i n excess of a s u s t a i n a b l e r a t e of f i n a l s a l e s growth, and werre e x p e c t i n g t h a t , by t h e end of t h i s year, a broader d e s i r e t o moderate i n v e n t o r y growth w i l l begin t o damp output s i g n i f i c a n t l y . We're a l s o looking f o r growth i n c a p i t a l spending t o t a p e r o f f by e a r l y next y e a r .
As i n d i c a t e d i n t h e t o p panel of c h a r t 5, w e have

p r o j e c t e d a s u b s t a n t i a l f u r t h e r i n c r e a s e i n r e a l business f i x e d investment over t h e second h a l f , i n l i n e w i t h t h e readings of recent surveys of spending p l a n s . I n 1989, though, less f a v o r a b l e f i n a n c i a l

c o n d i t i o n s and what might be c a l l e d t h e d e c e l e r a t o r e f f e c t of slower o v e r a l l spending growth t a k e hold t o damp investment. Equipment o u t l a y s a r e l i k e l y t o continue t o be by f a r t h e s t r o n g e r component 'of c a p i t a l spending; although burgeoning e x p o r t s make t h e o r d e r s d a t a somewhat t r i c k i e r t o read, t h e uptrend shown i n t h e middle l e f t panel p o i n t s t o s o l i d near-term g a i n s i n domestic investment. W a l s o expect t o s e e some growth i n i n d u s t r i a l e

c o n s t r u c t i o n , given t h e higher c a p a c i t y u t i l i z a t i o n r a t e s now

- 6 -

prevailing, but the trend in contracts shown at the right doesn't bode
well for total spending on nonresidential structures.
The bottom panels are intended to convey some sense of what the
economic projection may imply for corporate finances. If price
increases and profit margins are constrained in the way we are anticipating, then our forecast of business spending points to a rather sizable corporate financing gap. Moreover, interest coverage seems likely to deteriorate further, and these numbers bring to mind again the financial risks that may be lurking out there as a result of the heavy leveraging activity of the past few years. Turning now to the final exhibit in this segment of our
presentation, the top panel of chart 6 s m r i z e s the federal budget
picture. Our forecast puts the fiscal 1989 deficit above both the $136

billion Grm-Rudman target and the $146 billion trigger for
We can readily envision OMB coming up with a deficit estimate that is below the trigger. However, Administration spokesmen
have been making less optimistic statements, and it could be that there
is more going on here than simply an effort to discourage the Congress
from adding to expenditures.
Be that as it may, we've assumed neither a sequestration nor
any other new deficit-reducing action, and even so, the outlook for real
federal purchases, in the middle panels, seems to be one of restraint.
We appear now to be witnessing the effects of earlier cuts in defense
appropriations, and nondefense spending is leveling out as well.

- 7 -

At the same time, there is financial pressure at the state and
local government level, too--partly as a result of the oil patch
economic difficulties, but also reflecting in some cases a
miscalculation by states of the effects of tax reform. Despite the
substantial backlog of infrastructure requirements, we have projected
slow growth of real state and local purchases. This should move the
sector back into marginal surplus on an operating and capital accounts
Ted Truman will now discuss the outlook for the external


E M. Thm'dll . JUne 29, 1988


7, after the divider, prwides an werview of cur forecast
fm the

for the external sector. As canbe

panel, the deficit for real net exports of g c d s and services has been
narrmhg since mid-1986, and we are projecting a amtinuation of t his


r line in the top &

n trend. As is sham i the


panel, real exports of qcds are

plpjectea to cnntjnue to irrcl.ease rapidly this year ard next a t about 18
!the hcrease

in inports of gocds is pmjectedto so to the 3 lw
lwels of resource

percent range.
It is these trenls, mnbined with the hi

utilization n m prevailing in the U S econamy, that prduce the tension ..

i the s t a f f ' s forecast between inflation ard adjustrent. h-essures are n
being exerted on d&ic

msxrces frcan the ongoing process of external

adjustment: the issue is the manner in which they w i l l be manifested:

to what extent w i l l Urey result in higher inflation: alternatively, to
what extent w i l l restraint be exerted on d&ic




That is t e bad news; the god news, sham in the black line in h

the upper panel, is that the aurent aaxunt deficit i m n i n a l tenns has n
finally begun to nanxw. forecast period, a l -

We also e x p c t this trend to continue over the

the pace of adjustrwrt w i l l be

slak~er in


T e mm definitive evidence of inprwemnt in a r extemal h

ac0xnt.s is undcxlbtedly m e of the principal factors &lying finmsess of the dollar m
y .


As is illustrated by the red line in

- 2 -

the tcp panel of t e next chart, the foreign exchange value of the dollar h

i n tears of the other 0 1 0 currencies cm June 28, yesterday, was abcut.
7 percent above

its average level in Ikcenbx of 1987. WLle the

recareryofthedollarthisyearhasbeensubstarrtial, i t i s n o t n w h
1 than the t l o z q mple that ocaured between My and Augu5t a

of l a s t year.
?dthcaqh the nanmdng of the U.S. external deficits appears t o
have been the major factor behird the performance of the dollar so f a r i n
1988, the stance of

the Fecaerdl F?seme ard the d a t i v e rise i n U.S.

real lOrKJ-te?3n interest rates, which

is agproxilmw by the red line in


Howwer, we believe that the

f r h r progress on ute

external adjustment and relative restraint i n U.S. monetary policy w i l l

As Mike

precise, we have inzorporated into our forecast a ncmindl depreciation of


be sufficient t o prevent a further mderate decline i n the dollar.

noted earlier, w are projecting that the dollar w i l l
'b be I

its decline against the other 0 1 0 currencies.


the dollar i n terns of the currencies.of the other -10 ccuntries a t a

annual rate fmn the averaq lwel in June.

'Ihat inplies a

SaneWfLat faster rate of depre2iation ham the June 28th lwel plattea on

the chart. Because of the higher rate of inflation projectad for the

United states, the projected depreciation i n real terns i d y abart 5 s
percent a t an annual rate.
Chart 9 presents the staff's outlook for eaprmic activity

abroad. Gmmth i n the major foreign inkstrial
year or
3 0


over the past

has been satwhat mre rapid than had been



grwth has baen associate3 primrily w i t h varicus categories of

investment spenling ard, to a lesser extent, w i t h rmr;lmatian plrchases.
However, special factors such as urawally gccd weather ard the
statistical influeme of leap year m y have boosted the figures adually a

Lecozded for the f i r s t quarter of ulis year.
We amtinue to see a difference between the paof econmic

grawthincanada, Japan, ardtheUnite3Khgda11, s h u m i n t h e u p p e r l e f t

panel of the chart, ard that i n France, camany, and Italy, Shawn i the n
right panel.

Over the forecast perioa, we expczct the expansion of total

darestic daMnd -the red lines -to continue to exceed that of real GNP

- the black lines - in bath g - r u p of mtries.
~ v e r

Hawever, we

e%pezt grwth to so lw

the b a l m of 1988 and into 1989 u n d a the

influeme of tighter mDnetilzy and fiscal policies.
I n Japan, the package of fiscal measures intrduC e d l a S t y e a r

sucrmssfully stinulated dawstic daMnd, ard we do not expect further expansionary actions, given the hoyant level of activity achieved and therapidgrawthofnuney.

authorities are clearly omcerr& about a h i l d u p in inflation pressures
ard are moving to tighten

nrmetary policies. III Germany the unemplayment rate remains high, kR w i t h mmetary grmth above target and given
prwicxls ple3ps to return to fiscal rectitude, the expansion in e m d c

activity that extended into the f i r s t quarter -ides
the m v toward restraint that is already under way. oe

a rationale for Despite the


of high unaployment,

France ard I t a l y have little scq?e to

stinulate their eamuies, given their grawirrg external imbalances.

- 4 -


in the develcpkg countries is also eqeAed t o be lower

average i n 1988 than was recorded in 1987, especially in Latin
Hawarer, a pickup


in 1989 should help to sustam theaverage '

gmwth of econaRic activity in a l l fomign countries, Shawn in the lower

left panel, a t about the same 2-y2 percent rate as this year. such an

rate of expansion of foreign real


next yearwxlld be about a
right panel

1/2 a penentage point higher than that Shawn in the 1 -

for the united states, reversing the pattern of 1987 and 1988.

The behavior of COBRlIxLl 'ty prices, illustrated i n the upper left

panel of the wct chart by the staff's exprimental index excludirg crude
o i l , is one of the badqzcm3 factors amtributiq to SooReWhat greater

caution in policymaking i n other industridl axntries. A t the same time,
thistren3inCOBRlIxLlty prices is a soume of '
among the developing countries.
other broad

for ex~~rters

Cm the basis of the index sham and m t

indexes, dollar prices of axmdities on average now exceed

the previous peak for this recovery. Mthough mch of the reoent run up

incann>s prices has teen associated w i t h the adverse impact of 'ty
drm@t corditions in the United s t a h , canaodlty prices had been rising '

on average for mre than a year prior to their latest surge.
An additional factor &lying

m e s tamd greater policy

restraint i n the major foreign m i a l cumtries is the smaller margin
of excess manufacturing capacity rn prevailkg in the m r l d fxxmcmy. As

is Shawn in the upper right panel, in the f i r s t quarter of this year
capacity utilization rates in mnufacturiq on average in the six major foreign industri a l eccmanies exceded the prwious peak a t the beginning

- 5 -

o and the united ~ i r q k a u , ole has to g back a t least u of 1980. F r ~apan

to the early 1970s to find similar rates of capacity utilization. Meanwhile, as is .sham by the red line in the 1 left panel,

wholesale prices in the major foreign in3ustrial countries have been

rising, an a year-overyear basis, since the m i m e of last year.

m u w = of the mnstrudion of saw of the foreign wholesale price

irdexes, the influMce of increases in c�mrcdl prices i l q e r than i 'ty s n
the U.S. pm for finished gods. Nevertheless, the trend is inaicative

of an end of the deflation of recent years and of the emergence of an

environment in whi& inflation is mre w o r r h .
%his trend can also be seen
collsumer prices .sham by

i n the gradual acceleration of

the red line in the riqht panel.


inflation in the major foreign iniustrial axlrrtries is projected to rise
a b i t further over the forecast pericd.

However, as I noted earlier in

connection w i t h my discllssion of the autlook for the dollar, on average foreign inflation is
Against the bac)cgraund of exprdhg d

to be s u t s b r h 'ally less than in the united

d abmd, rising rates

of capacity utilizatim, and the increased price cmptitiveness of U.S.
gods, the volume of u S nmaqricultural exports has been gmJing ..

rapidly, as s h a m in the upper left panel of chart 1 . As ycm can see 1
frtanthedatainthetable, g m w t h i n t h e v o l u w o f suchexports

accelerated over the past year, and it has been b m d l y based, though the pickup in exports of business machines and other capital g c d s has teen
particularly prormnced.

- 6 -

Moreover, the value of cur mnagriculbral exprts to a l l major
a m a r k e t s h a s b e e n ~ t annual rates of 20 percent or mre, much '

mre rapidly than the expansion of aggregate ckmrd abroad. 'This
suggests that the daninant factor underlying the
been our inprwed price cmptitiveness.
of exprts has

Hmever, rapid grayth in

daaestic demani in the Asian NICs and Japan has boosted exports to that
area relative to the overall average.

As can be sesn in the right panel, we are projecting a cmntinued

expansion in the volume and value of


nonagriatural e x p r t s

over the forecast period.

m e r , the gzwth will be a t slightly less

than the exceptional rate of the past fcur guarters, in part, because of
a &cp off i n aircraft deliveries i n t e seconl half of this year. h

nnniq to a g r i d t u r a l exports, the
- i d


left panel, we have

a significant -cry over the past year in this area, as

In l a t e 1987 and the f i r s t half of 1988, shipwlts to the Soviet

union and china have been substantial. nwwer, the backlog of corrtracts
for deliveries to these two Countries has been largely eliminated.
i t s e l f , this wauld contrihte to a dxqmff

in agricultural shipwnts in

the seand half of the year.

In addition, we have h r p r a t e d into the

forecast an adjustmnt for the effects of the d r a q h t on available exprt

m s a s c a n b e s e e n f r a n t h e r e d l i n e i n t h e c h a r t , thevolme u,


exprts is projected to

amp off, but the reduction in


- the black line - is a p c b d to be substantially smaller
Next year, an anticipates recarery in the

because of higher prices.

volume of agridtanal exports and only a malest easing in prices wer

- 7 -

the a m of the crop year are projected to generate abart $42 billicol m e

in agricultural wt r s

- close to the recod level of



tallied i n 1981.
I e situation w i t h respect to oil impoas is h

sunnumized in the

larer right panel.

over the p r o j d o n pericd ws are asslrming that the
in excess of the agreed

availability of OPM: m l y i nat materially changed fmm the current s
average of about 1.5 million barrels per day

lwel of OPM: quotas, and w are projedirq that the average price of
importea oil w i l l recaver after the dip to $15.25 per barrel in the f i r s t

guarter of t i year. W expsct the price to clirrs, back to $17 dollars a hs e barrel by the fcurth quarter. 'Ibis lwel of pries WaiLa be mre i n line
w i t h OPEC's official average price of $18 per barrel.

F r next year, we o

are pmjectixj a further inuease of $1 per barrel.
With daw&x'c demand projected t o rise about 200 thousard

barrels a day next year and danestic production proje%ed to decline by
akmt the same anumt, o i l inportS s h d d rise to dLmost 8 million

barrels a day by the end of 1989. Their value w i l l be arouxl $50 billion

at an annual rate.
I e next h

chart deals w i t h --oil


As can be seen i n

the battcm line of the table in the upper left panel, the average price
of non-oil imports increases by mxe over the f a r qua?AAm ending in

March than it had over the F i c u s f a r quartem. However, much of the i n c r e a s e h a s ~ f r u n i n c r e a s e s i n a m m K % l lprices as reflected in 'ty
the prices of importea food and im3ustrialsupplies.


prices of a l l the categories of non-oil i n p r t s , aside fmm kusiness

- 8 -

madlines, have amtired to rise mre rapidly than the general price

AS can be

in the table i n the right panel, this has lad to

a marked s l a w i n g in the gmwth of the v l om of non-oil imports, w i t h the notable exception of imports of business machines and other w t l id


'Ihese Ism categories, which accnunt for ahxt

one thi.1~3of the

t t l value of our m-oil imports, have been stimlated by the highex oa
investment demand in

ax projection for the average price
that the average price, measured

I e lam- left panel shows h

r of ncor-oil imp3rts. We a e project-

by the fixed-weight index, w i l l incl.8ase abcut 10 pexent this year
before slawinq to about 7-1/2 percent next

under the influence O f

the projected slaw rate of depreciation of the dollar and mre moclerate
W i n C Q n n K d l'ty prices.

i sham in the 1 s vl ow of such imports

right panel, the expansion of the

- the red line - is projeded to be moderate
T h e mall

over the entire perid, consistent w i t h the s l o w i n g of overall dcanestic

demard as w e l l as w i t h higher prices for iuprted gods.

increase in import v l in our forecast is entirely accQunted for by ow
b i n e s s machines. Hcwver, the value of non-oil imports w i l l continue

to exprd rapidly because of the ccntinuing rise in their prices.
chart 13

the s t a f f ' s projection for the extemal

T e trade balance h

- the black line in the top panel - i s
by the fall-off in agriculixral exports

projected to resucm its recent trwd of irrprwement after a pause in the

secoml half of this year p0 -4


ard the pickup in o i l prices. I might also note that cur projedion

assumes that the trade deficits in My and June were substantially larger a
than that - m 3 d
for April.

In any case, by the enl of next year, the

trade deficit is project&
rate, aapared w i t h year.

to narrw to alnnst $100 billion a t an annual

$144 billion

in the f i r s t guarter of this

The i n p r o v d in the am-ent ac(rxllt deficit

- the red

US ..

- is projectea to be abuxt the same.

'Ibis improving trend i n the

a m t is expected to generate an almsst imperceptible

sla&g i n the deterioration of the U S intematioMl investment ..

position, depicted in the lower panel. As a nxqh ~ m - t i o n ,


U.S. trade deficit would have to be eliminated entirely i onler to n

stabilize the r a t i o of


net in3ebtedxs relative to ncanindl GNP,

c might be viewed as a sustainable mndition. h

such considerations

t e s t a f f ' s view that the dollar w i l l m t i n u e to ccane d e r h
and w i l l a t scsne point depreciate forther in real

P -

Nevertheless, the projected improvement i n cur external accounts
over the forecast period is substantial, ard the issue is whether an

inpmvement on the scale we are projecting can be accanplished s n w t h l y

W e avoiding excessive pressures on danestic resaurces and a n
aozderation of inflation.
Larry Slifman w i l l naw continue ax presentation with a

dixussion of the inflation outlook.

Lawrence Slifman
June 29, 1988



As Mike noted earlier, the drought has had a noticeable effect

on our psojection for GNP.

It also has altered our price forecast. As

shown in the upper panel of chart 14, we expect consumer food prices to
rise rapidly over the remainder of this year. In quantifying the
drought effects, we have relied in part on the signals from the
conunodity markets.
Of course, if the weather turns out to be even worse
than the markets thus far have anticipated, the near-term outlook for
production and prices would worsen considerably. Next year, however, we

assume more normal weather patterns and an easing in government acreage
set-aside requirements. This generates more production, and in
response, food prices are projected to rise at a slower rate than
overall inflation.
We recognize that beef prices will likely move in a different
direction--falling in the near term as cattle are sent to slaughter and
then rising sharply next year. Nonetheless, past experience suggests

that, overall, retail food prices tend to rise at the time the drought
affects crops, reflecting fairly prompt changes in prices of products
most directly associated with grains--for example, cereal and bakery
items, poultry, and vegetable oils.
In contrast to food prices, we think energy prices will be
quiescent over the next year and half. As Ted noted earlier, we expect
the price of imported oil--the middle panel--to climb to $18 per barrel

- 2 -

over the projection period.

Given this path, and looking at retail

mrgins and other factors, retail energy prices are projected to be a
moderating force on overall inflation.
In terms of non-oil import prices, the effects of more than three years of dollar depreciation have become increasingly pronounced. The lower panel shows a measure of import prices that excludes not only oil but also business machines, in order to eliminate a distortion caused by the fact that for computer imports the current practice at the Commerce Department is to actually use a price index for U.S. produced computers. Although we expect the rise in prices of imports to moderate somewhat, it is large enough, in combination with some lagged effects from earlier increases, to account for about half a percentage point or
so of

overall consumer price inflation in both this year and next. The

effect on domestic output prices would be smaller--for example, about a
quarter of a point on the GNP fixed-weight price index.
Your next chart addresses the issue of supply problems in the
industrial sector. To date, most reports of capacity constraints or
product shortages have been confined mainly to materials. To assess the
seriousness of the problem, the top panel compares the percentage of
materials-producing industries currently operating well above normal
utilization rates with the numbers in earlier periods. Eighty-nine non-

energy materials industries have been classified into four groups: the
heavy black bars are for those operating well below normal--that is,
with utilization rates more than one standard deviation below their
industry long-run averages; the lightly striped black and red bars

- 3 -

indicate those operating at close to average rates; and the heavy red
bars denote those operating more than one standard deviation above
As can be seen by comparing the two sets of bars on the left, since late 1985 and early 1986--when pressures in materials markets were almost non-existent--slack has disappeared rapidly and the distribution of utilization rates has shifted considerably, with nearly a quarter of materials industries now operating at rates significantly above their long-run averages. By way of comparison, in late 1978 and early 1979, when prices were rising very steeply, some 3 4 percent of materials industries were operating well above normal. This same story of rising pressures in materials markets, but short of previous peaks, is indicated by data from the survey of purchasing managers--the middle two panels. As you know, purchasing managers are asked to identify industrial items in short supply. We have gone through the reports for the past decade, and divided the items mentioned into 21 broad categories. Currently, items are being reported in short supply in 43 percent of the categories. Another indicator of possible supply problems is the report on lead times for ordering production materials. As shown in the middle right panel, average lead times have moved up only moderately since late 1985--clearly a less ominous picture than that painted by the short supply list. On balance, the evidence suggests that the economy is not
facing major supply constraints, despite a few specific problem areas.

- 4 -

Nonetheless, reduced overall slack in materials markets already has been
associated with higher prices for many industrial commodities. In terms
of the outlook, although materials inputs generally are a relatively
small part of overall production costs, these price hikes likely will
have some noticeable effects on aggregate inflation.


shown in the lower panel, there is considerably more slack

in the advanced processing industries. But even in that sector, operating rates have been moving up for the past year and a half-­ especially in those industries benefiting directly from brisk export growth. Given our projection of relatively slow growth in domestic demand, the utilization rate in this sector is projected to level off soon and then edge down, thereby avoiding any serious supply difficulties. However, should this slowing fail to materialize, while the external sector continues to strengthen, capacity pressures undoubtedly would begin emerging before too long.
Your next chart focuses on the influence of labor costs on the

inflation outlook.


shown by the red line in the upper panel, the

acceleration of consumer inflation in 1987 cut sharply into real compensation per hour, reflecting the tendency of wage increases to lag price increases. Looking forward, we are forecasting little change in real pay rates. Labor markets currently are relatively tight, with reports of hiring difficulties in scattered areas and occupations. However, in o u r forecast, unemployment rises a bit, and this, in combination with continuing competitive pressures in many industries, is

- 5 -

projected to hold nominal wages to an increase no larger than that of
consumer prices.
The offset to accelerating nominal wages from productivity gains is projected to diminish. As shown in the middle panel, during the initial phases of the current cyclical expansion, productivity grew rapidly as businesses were able first to utilize more fully their existing staffs and then re-employ or hire the most able workers. The result was that output per hour rose rapidly, moving well above its longer-run trend. But with the margin of slack in many labor and product markets relatively narrow, the quality of new hires probably has deteriorated, and they may be working (at the margin) with less efficient capital. Consequently, productivity is anticipated to drift

back toward its long-run trend line over the next year and a half, rising at less than a 1 percent annual rate on average. Reflecting these wage and productivity developments, unit labor costs--shown in the bottom panel--are projected to rise at nearly a 4 percent annual rate. Thus, while price developments in the food and energy sectors should be favorable next year, unit labor costs will be providing some momentum to overall inflation. Mike will now conclude our presentation.


Michael J . Prell June 29, 1988



The top panel of the last chart presents an alternative to our
Greenbook forecast, designed to give you some idea of what the projected
rise in interest rates is doing to the economy. Because the lags tend
to be long, we extended our projection, in a tentative way, into 1990.
With interest rates probably easing back some from the 1989 highs, the
extension of the Greenbook forecast--labeled as the "baseline"--points
to continued slow growth, with little change in the unemployment rate.
Inflation edges off slightly in 1990--partly because of some carryover
of the late '89 deceleration of food and import prices.

I might note that, in formulating the Greenbook projection and

the extension into 1990, we have adopted what might be viewed by some as

a fairly optimistic view of the implications of the current level of the

unemployment rate for inflationary pressures. We are, in essence,
assuming that, whatever its explanation, the recent tendency for wages
to behave better than most models would have predicted will persist.
The lines labeled "stable rates" represent a model-based
estimate of what would happen if the federal funds rate were held fixed
at the current level through an easier monetary policy. In the staff

models used--as in most other models--wages and prices adjust slowly to
demand shocks, owing to backward-looking expectations and to contractual
rigidities. Consequently, an easier policy yields noticeably more
output and employment in the next couple of years, and the additional

- 2 -

inflation begins to become visible only late in the period.

The drop in

unemployment to around 5 percent by the end of 1990 probably would imply an appreciable further divergence of the two inflation paths in 1991. Finally, the bottom panel presents your forecasts, lined up
against those of the Administration and the Board staff. The range of
FOMC forecasts is broad, but the central tendencies are well defined.
There is little difference between the central tendencies and the staff
projection, except that the staff shows somewhat more inflation and a
touch higher unemployment rate over the remainder of this year.
Administration, on the other hand, differs substantially in its view of
1989, showing a good deal more growth, but no more inflation than is in
the central tendency forecast. You will recall that the Humphrey-
Hawkins Act requires the Board to tell the Congress whether there is any
conflict between the monetary ranges adopted by the FOMC and the Administration forecast. Since the Administration's nominal GNP figures

are only a little above the FOMC consensus and within the full range of FOMC forecasts, there does not appear to be a glaring inconsistency. It is interesting to note, however, that in the Adminstration forecast interest rates decline over the next year, which might imply a decline in M2 velocity--rather than the rise anticipated in the staff's projection. Mr. Chairman, that concludes our presentation.